It makes sense for stablecoin creators to peg their coins to a physical asset that is historically stable, although this is not a requirement.

A stablecoin that is pegged to a fiat currency still fluctuates with the price of the fiat.

Some stablecoins provide legal entitlement to the underlying assets and some do not. For the coins that do provide this, ownership of the coin means holders are entitled to the asset the coin is backed by as the coin represents ownership of the asset.

This means that all owners of the coin are legally entitled to the assets their coins are backed by if anything goes wrong with the network. The other type of stablecoin maintains a stable price in relation to a specific asset, but owning the stablecoin does not mean you are entitled to the underlying asset.

Why would you want a stablecoin?

Stablecoins maintain some of the same benefits as traditional cryptocurrencies - they are highly secure and can be transferred quickly with minimal to no fees.

Their primary use is as a store of value. Some crypto exchanges do not offer fiat pairs, but instead have pairs with fiat-backed stable currencies, which to many traders is the next best thing.

A stablecoin allows cryptocurrency traders to store value and avoid the volatility of the market. They are viewed as a great way to efficiently enter and exit markets, to either avoid volatility or to profit from it. Traders frequently utilize stablecoins to exit markets when they feel the price of a coin they are holding is going to decrease.

If a trader holds Bitcoin, and they are expecting a price decrease, they can sell their Bitcoin for a stablecoin, wait for the price decrease, and then buy back in. This maintains the value of their Bitcoin holding, but increases the amount of Bitcoin they have.

When Bitcoin increases, their percentage increase will be higher than before. This can of course be achieved by trading with actual fiat pairs if they are available. Liquid is a crypto exchange that offers fiat currencies such as USD, SGD and JPY.

How does a stablecoin work?

Stablecoins actually work in a variety of ways depending on how they are configured and what method is being used to maintain the price. Firstly, let's look at asset-backed stablecoins.

One of the most well known asset-backed stablecoins is Tether, which is backed by USD. Everyone who owns Tether is in theory legally entitled to the equivalent amount of their Tether in USD.

Therefore, the company behind the coin must own all the USD that is promised to the coin holders, and the coin holders need to trust the team that they actually own all of the required assets.

Coins of this regard operate fairly simply. When a user purchases one of the coins, the company behind the coin should ensure they own the asset required to back the coin and keep it stable.

In this case, for every Tether sold the company is meant to have USD1. When one of the coins is sold back to the company, it is exchanged for USD1 and the coin is burned.

For other asset-backed stablecoins the process is similar - the company behind the coin must ensure they own enough of the asset for the amount of coins issued.

If coins are bought, they must generate more coins and buy more of the asset.

If coins are sold, they must burn the sold coins and repay the customer. With stablecoins like this the users must trust a third party, which isn’t always desirable.

There are also stablecoins that are collateralized with cryptocurrency.

These remove the requirement to trust a third part because everything is carried out on the blockchain and executed by smart contracts. The issue with crypto collateralised stablecoins is you have to provide much more collateral than the coin is worth to account for the volatility of cryptocurrency.

Stablecoins that are not asset backed are much more complex. These coins are maintained to follow the price of a particular asset, but by holding the coin you are not entitled to the asset.

These coins are controlled by algorithms that are constantly changing the total supply of coins to maintain the price. The price can be maintained by utilizing a seigniorage shares system.

Simply put, when the price increases the algorithm will increase the total supply, and when the price decreases the supply will be decreased. Now let’s have a look at this system in depth.

The seigniorage shares system is controlled by a smart contract. Let’s say this coin is working to keep a stable price of USD1. If the price rises above USD1, the smart contract will increase the supply, selling off the tokens and drawing a profit. The profit is called seigniorage.

If the price dips below USD1, the smart contract executes the opposite. The seigniorage profits are used to buy back some of the supply to increase the price.

The tricky part arises when the smart contract runs out of seigniorage profits, but the price is still below USD1. In this case, seigniorage shares have to be issued, which are sold to buyers with the promise that they will be reimbursed with future seigniorage.

Once seigniorage shares are sold, the smart contract will have enough funds to raise the price to USD1. Issues begin to arise when there are no buyers for the seigniorage shares. If this is the case, the project will fail as the price cannot be maintained and community sentiment will fall dramatically. Therefore, this model relies on continuous growth of the community, with an increase in demand for the coin.

What are the drawbacks of stablecoins?

Stablecoins serve a valuable purpose, but they also do have downsides that need to be recognized.

Third-party trust is essential - stablecoins are inherently centralized in some way. This goes against one of the fundamental benefits of blockchain technology, the removal of the requirement for third-party trust when looking after your money.

You have to trust that the issuer of the stablecoin either has the assets required to back the coin, or their algorithms are rock solid. This isn’t immediately a problem, but it is something that must be taken into consideration.

Fiat-collateralized stablecoins are not truly stable, because they are affected by the price fluctuation of the currency they are tied to.

If a coin were actually stable, the amount it could purchase would remain the same, rather than the arbitrary price. Furthermore, fiat-backed coins act as an iteration of an existing currency, so it is more probable that they will be hit hard by regulation.

For cryptocurrency-collateralized stablecoins, you have to over collateralize to compensate for the volatility of the crypto. It is also possible in this case for the collateral to become worthless, and for the stablecoin system to consequently fail.

The history of stablecoins is rocky at best. Almost all of the past attempts at stablecoins have failed. For example, BitShares was created to be pegged to USD, but just a few days after launch the system failed. This doesn’t mean that current stablecoins are doomed to fail, but it's important to remain objective.

These projects can fail. It is very possible for a non-asset backed stablecoin to sharply decline in price. If the community loses faith in the project, the token issuer will be unable to raise the funds required to buy up units and decrease the supply of the coin to raise the price to the required level.

As the price cannot be maintained, it will sharply fall once this is recognized. Therefore, this model suffers if the demand of the coin does not continuously increase. If there is not a constant stream of new investors, the price staying stable is unsustainable.

Stablecoins have their ups and downs, but they do provide a new dynamic to the cryptocurrency landscape.

This content is not financial advice and should not form the basis of any financial investment decisions nor be seen as a recommendation to buy or sell any good or product. Trading cryptocurrency is complex and comes with a high risk of losing money, particularly if you trade on leverage. You should carefully consider whether trading cryptocurrencies is right for you and take the time to learn how trading works and decide how much money you are prepared to lose.